HOW TO MANAGE EARNINGS MANAGEMENT1

HOW TO MANAGE EARNINGS MANAGEMENT?1 By Partha S. Mohanram Assistant Professor Graduate School of Business Columbia University ________________________________________________________________________ ! '( () -% & , $%. 2 3 , / 5 # # 6 # 2 4 * -* 6. 22 # 2 2 , /1 /0 * * 0 " # + / 0 / $% %& , 1 # 4 2 2 , 2 2 2 4 2 2 2 This article was published in the October 2003 issue of Accounting World, a monthly publication of the ICFAI, the Institute of Chartered Financial Analysts of India. 1 1. Introduction Earnings management has become an issue of critical importance in today’s capital markets. Hardly a day goes by without some mention of a large firm that misled investors through the intentional misstatement of financial statements. Understanding what earnings management constitutes and why it takes place is essential for users of financial statement information. This article illustrates the different aspects of earnings management by defining what it constitutes, identifying why firms manage earnings, illustrating how firms manage earnings and demonstrating when they are most likely to manage earnings. It also will lay out some simple techniques for detecting and adjusting for earnings management. The primary basis for this paper is the growing academic research in this field over the past two decades. Earnings management is the intentional misstatement of earnings leading to bottom line numbers that would have been different in the absence of any manipulation. When managers make decisions not for strategic reasons, but solely to change earnings, one can consider that to be earnings management. Earnings management does not always have to mean upwards manipulation. As will become apparent through the course of this article, there can be many instances when managers intentionally misreport earnings downwards. This is especially likely to happen when firms are either way above or way below their targets. Earnings management does not always have to be related to changes in accounting practices. For instance a firm may speed up sales to customers by providing them with greater discounts and more flexible credit terms at the end of a fiscal quarter or year in order to meet targets. This will probably come at the expense of future sales, but this is an example of earnings manipulation driven by strategic actions as opposed to changes in accounting. Earnings management also does not have to be related to the smoothing of earnings. The popular notion has always been that managers prefer to smooth their earnings and this makes their firms appear to be less risky. However, there can be instances where greater volatility can be of interest to managers, leading them to manage earnings in a direction that increases volatility – for instance when managers own a large number of stock options. 1 Earnings management also does not have to be illegal. In most cases, what managers are doing is completely legal. They are using the discretion at their disposal to present their financial results in a manner that best suits their interests. 2. Why Do Firms Manage Earnings? There are manifold reasons for why managers manage earnings. At the fundamental level, the reasons are related to the performance of the firm with respect to some benchmark. This benchmark could be the previous period’s performance (the desire to show an improving trend), analysts expectations (the desire to meet or beat expectations), “zero” (the desire to remain profitable), or whatever benchmark is specified in a manager’s compensation contract (the desire to meet a bonus threshold). Missing these benchmarks can be extremely costly because the relationship between stock price (or compensation) and earnings is very non-linear around the benchmarks. A firm that missing an earnings target by a mere cent may see its stock price decline precipitously, while a firm that beats a target by a few cents may see a nice boost to its stock price. Little wonder that the instances of firms missing their target by a cent are tens of times less likely to occur that firms exactly making or exceeding their target by a cent (see DeGeorge, Patel and Zeckhauser (1999), Burgstahler and Dichev (1997)) When firms are extremely close to a target, the incentives to take earnings just over the target becoming exceedingly strong. In these cases, the firms will try and use some form of upwards earnings management to “bump up” earnings over the target. However, when firms are way below their targets, they have an incentive to make things look even worse for the following reasons. Firstly, it is highly unlikely that any amount of earnings management will get them over the target. Secondly, if one is way below the target, the costs of being even worse are typically minimal. Such earnings management is referred to as “big-bath” accounting. Typically, firms will take large restructuring charges, increase provisions for bad debts and take other income decreasing accounting decisions. Given the self-adjusting nature of accounting, these will lead to boosts in future income in the form of expenses that will not need to be recognized. Further, any improvements in performance will look even more creditable. Managers will get greater credit for turning around a firm, although a substantial portion of the 2 turnaround may be an artifact of the accounting. This point is well illustrated in the following excerpt in a speech made by Arthur Levitt, former head of the SEC.2 “Companies remain competitive by regularly assessing the efficiency and profitability of their operations. Problems arise, however, when we see large charges associated with companies restructuring. These charges help companies "clean up" their balance sheet - giving them a so-called "big bath. Why are companies tempted to overstate these charges? When earnings take a major hit, the theory goes Wall Street will look beyond a one-time loss and focus only on future earnings. And if these charges are conservatively estimated with a little extra cushioning, that so-called conservative estimate is miraculously reborn as income when estimates change or future earnings fall short.” When firms are way above their targets, they may again have an incentive to reduce earnings. Typically, there is little benefit in going way above a benchmark. Consider a firm which expects to report an EPS of $2.50 for a given quarter when expectations hover around $2.00. Such a firm may want to report an EPS of $2.30, still comfortably beating expectations. The 20 cents of EPS reduction may come in handy in future quarters when the firm is slightly below targets. Further, reducing the extent of over-performance prevents the ratchet effect. The ratchet effect is when expectations are adjusted upwards when performance is strong. If firms do too well, expectations for the future are adjusted accordingly making future targets more difficult to attain. Earnings management of this nature is referred to as “cookie-jar” accounting. By reducing current period income, firms implicitly save some of these excess earnings for the future when they may be more valuable. The figure below illustrates the behavior of managers around targets and highlights the three different kinds of earnings management discussed above. Speech Entitled “The Numbers Game” by Chairman Arthur Levitt of the SEC at the NYU Center for Law and Business, Sept 28th, 1998. 2 3 TARGET BIG BATH BUMP UP COOKIE JAR Researchers have also identified other reasons for managing earnings – for instance, the incentive to get options at as low a strike price as possible and the incentive to exercise them at as high a price as possible. Researchers such as Aboody and Kasznick (2000) have shown that managers are more likely to postpone disclosures of good news and accelerate negative disclosures in the time periods just prior to option grant awards. As options are typically granted at the money, this allows them to get options at a potentially lower strike price making them more valuable. Recent research by Bartov and Mohanram (2003) has shown that managers adjust the stream of earnings by using income increasing accounting methods in periods prior to large exercises of options and income decreasing methods thereafter. 4. How do Firms Manage Earnings? Firms have a variety of different options when it comes to managing earnings. The most common methods involve changing the assumptions for accounting standards. Most of this arises from the flexibility that GAAP usually allows. From the outside, it is difficult to ascertain whether these changes represent manipulation or the genuine application of managerial discretion. This allows those who do manipulate to get away with it as one cannot for sure attribute these changes to manipulation. For instance 4 managers can adjust depreciable lives periodically and justify it on the grounds that the change brings them in line with industry standards. An example of this was seen in the case of Southwest Airlines which increased its depreciable life from 20 years to 25 years in 1999. What this did was allow Southwest to keep its record of always showing increases in earnings intact. Other methods that firms can use include the capitalization of expenses previously expensed, increasing the extent of capitalization, slowing down amortization of previously capitalized expenses and reducing the provisions for bad debts. Firms can also reduce income by taking on large one-time charges. These charges can be used for taking big baths in bad times or creating cookie jar reserves. Microsoft Inc. recently settled charges with the SEC regarding the use of cookie jar accounting rules. The allegation was that Microsoft deliberately slowed down the recognition of top line revenues and consequently bottom line income in good years so that it could potentially tap into these cookie jars in lean times. AOL was also forced to reduce some of its restructuring charges associated with acquisitions in made in the late 90s, because the SEC viewed them as padded up big-bath writeoffs, which would be used to prop up future income. Firms can also manage income through managing transactions. As disclosed earlier, managers can accelerate revenue recognition just prior to the end of a fiscal period. In some cases, these last minute sales are genuine sales. In other cases, they are attempts to get inventory off a firm’s books and have it booked as revenue, even if the buying firm does not agree to buy the additional quantities. Such attempts are referred to as “channel loading”. Firms that indulge in channel loading will typically show symptoms such as a large increase in receivables relative to sales. In extreme cases, some firms have been caught indulging in outright fraud, by hiding inventory, moving it to unnamed warehouses and booking it as sales. A classic example of this was the case of Sunbeam Inc., which showed amazing turnarounds in performance in the late 90s under the leadership of “Chainsaw” Al Dunlap. It turns out that much of turnaround was an artifact of accounting manipulations and outright fraud. Sunbeam transferred ownership of products to retailers and gave them an unheard of six months to pay even as it retained the physical inventory in its warehouses. 5 Fundamentally, most earnings management is based on accruals. Accruals are the differences between earnings and cash flows. Most accounting decisions involve some accruals. For instance, selling on credit leads to the creation of accruals because the sale is recognized along with a receivable, even if there is no cash received as yet. Most accruals are a normal part of a firm’s business and tend to reverse out over time. A receivable today disappears when cash is received. Most accruals are in place simply because accounting principles such as matching that try to get a better economic measure of period performance than cash flows. The critical aspect is separating out the discretionary and non-discretionary accruals in a firm’s financial statements. Earnings management can be considered as an “inter-temporal” transfer of income between periods. If a firm is aggressive with its accounting, it is in a sense borrowing from the future. If a firm is conservative, it is saving up for the future. None of this matters in steady state, because of the natural reversal in accruals. However, when firms are growing, they can be aggressive with their accounting and get away with it, much like nations that run manageable budgetary deficits. When the growth a firm is experiencing reverses, the aggressiveness in accounting manifests itself. Little wonder that there were few accounting scandals in the height of the technology boom while there has been a spate of such scandals in the recessionary environment since. In the following two sections, two approaches to detecting earnings management are identified. The first qualitative method is based on a detailed analysis of a firm’s accounting policies. The second analytical method is based on a quantitative analysis of accruals. 5. Detecting Earnings Management Qualitatively: Accounting Analysis Understanding a firm’s accounting is crucial in attempting to identify potential earnings management. Provided below is a framework to carry out accounting analysis.3 The first step in accounting analysis is identifying what the key accounting policies are for a given firm and industry. For example, for banks, issues of credit risk and interest rate risk are of crucial importance. For airlines, it is probably depreciation. 3 This framework is based on the Accounting Analysis chapter of “Business Analysis and Valuation” by Palepu, Healy and Bernard. 6 Identifying the key accounting policies allows one to focus on areas where manipulation is most likely to occur. The second step is assessing a firm’s accounting flexibility. How much flexibility does the firm have in choosing accounting policies? For some firms, this may be very low because GAAP accounting is very restrictive (R&D, Marketing Costs). For others, it may be high (e.g. credit risk). How much of the flexibility have managers used up? Are they currently being aggressive or conservative? Firms that are currently conservative potentially have greater scope to boost earnings through aggressive accounting. However, firms that currently have aggressive accounting may have a greater propensity to manipulate and may be forced to resort to potentially illegal accounting techniques. The third step is the evaluation of a firm’s accounting strategy. How does the firm' accounting strategy differ from that of its competitors? Have the firms accounting s policies and estimates been realistic in the past? Has the firm changed any significant policies and what has been the impact? Do managers have incentives to use accounting opportunistically (covenants, compensation)? If a firm has a track record of clean accounting and realistic assumptions in the past, then any changes in accounting that such a firm implements is more likely to be genuine as opposed to manipulative. The fourth step is to evaluate the firm’s quality of disclosure. Does the firm provide adequate information to assess its strategy and understand the economics of its operations? Are accounting policy choices justified adequately? Is there detailed assessment and analysis of past performance? If accounting is restrictive, does management provide additional disclosure to help better understand financial statements? Is there detailed segment disclosure - geographic as well as business segments? How good is the firm’s investor relations program? Does the firm provide equally good disclosure for bad news? Disclosure quality and accounting quality are inexorably linked. Firms with transparent disclosure practices are potentially far less likely to indulge in earnings management. The fifth and potentially most crucial step in accounting analysis is the identification of red flags. The table below provides a representative list of potential redflags in accounting. Note that these are potential red flags. The presence of one or a few 7 of these may not signal anything negative, but if many of these red flags do come up for a firm, further scrutiny is certainly required. Potential Red Flags • • • • • • • • • Unexplained accounting changes, especially if performance is bad. Unexplained profit boosting transactions - e.g. sale of assets. Unusual increase in Accounts Receivable in relations to sales increase - relaxing credit or loading sales channels to boost revenues. Increasing Gap between Net Income and Cash Flow from Operations: Firm might be "fiddling around" with accruals. Increasing Gap between Net Income for reporting and tax purposes. Unexpected large asset writeoffs or writedowns Large fourth quarter adjustments Qualified audit opinions or change in auditors Large Related party transactions The final step is to undo accounting distortions by reversing out the impacts of dubious accounting choices wherever possible. For instance, if a firm has increased depreciable life from 15 years to 20 years in a manner that appears to be manipulative, one should restate the numbers with depreciable life of 15 years. The cleansed financial numbers should instead be used for financial analysis. 6. Detecting Earnings Management Analytically: Discretionary Accruals Accruals are defined as the difference between Net Income and Cash from Operations. At a first pass, firms with a high level of accruals are likely to have inflated earnings. However, using total accruals as a proxy for earnings management is simplistic because firms can have high accruals for reasons such as growth in sales (increase in receivables) and additions to property plant and equipment (increase in depreciation). Many researchers in the field of financial accounting have tried to measure earnings management by disentangling accruals into discretionary accruals and non-discretionary accruals. An example of a commonly used model is the Jones model, based on a paper by Jones (1991). The model runs a multiple regression with total accruals as the dependent 8 variable. Independent variables include controls for growth in revenues and property plant and equipment (PP&E) and receivables. Controls can also be included for actual performance as recent research shows that firms with strong economic performance tend to have higher accruals even in the absence of earnings management. The Jones model can be implemented in time-series (i.e. for a given firm using a time series of past information) as well as in cross-section (i.e. for a given industry at a point in time). The cross-sectional model is preferable as one does not need too much prior information. The basic estimation equation is as follows. Total Accruals t Gross PPEt Re venuest − Re venuest −1 1 = β1 ( ) + β2 ( ) + β3 ( ) Total Assetst −1 Total Assets t −1 Total Assets t −1 Total Assets t −1 where Total Accrualst are measured as the difference between income before extraordinary items and cash flow from operations in year t, Revenuest is revenues in year t, Total Assetst-1 is total assets at the end of year t-1, Gross PPEt is gross property plant and equipment at the end of year t, and β1, β2, β3 are industry and year specific parameters to be estimated. The fitted value from this regression gives us an estimate of the non-discretionary component of earnings. The residual value from this regression is the discretionary accrual for a firm in a given year. Firms with high positive discretionary accruals are likely to be managing earnings upwards, while firms with low positive discretionary accruals are likely to be managing earnings downwards. The methodology for inferring discretionary accruals is undoubtedly noisy because it artificially imposes structure where none may be applicable. For instance, running this analysis in time series assumes that the firm ought to have the same amount of accruals over time after controlling for growth. Running the analysis in cross-section assumes that all firms in a given industry ought to have similar accruals. These are strong assumptions, but empirical tests indicate that they are generally valid. Many research papers have indeed found that discretionary accruals are a valid proxy for the incidence of earnings management (see Dechow Sloan and Sweeney (1995) and Bartov, Gul and Tsui (2000)). 9 8. Implications Earnings management is a reality of today’s capital markets. This article has exposed the reader to the nature of earnings management and tried to identify methods by which earnings management can be detected. This has important implications for different participants in the financial markets – investors, financial analysts, the business press, regulators, auditors, academics and the firms themselves. In spite of the fact that earnings are managed, it would be naïve to say that one ought to go back to cash flows. Managed earnings are a reality in a world where managerial discretion can be used manipulatively. That does not negate all of accounting. Empirical research shows that net income, warts and all, is still a far better predictor of future performance than cash flows. In fact, it is even a better predictor of future cash flows than current cash flows (see Dechow (1994)). The notion that cash is king is misleading. Earnings that have a high correlation with cash flows (i.e. low levels of accruals) are indeed higher quality earnings, but earnings in general are a better metric than cash flows for the purposes of performance evaluation, prediction of future performance and valuation. The basic takeaway is not to abandon earnings, but to adjust them to mitigate the effects of potential manipulation. An insight into how managers can manipulate earnings is essential for capital market participants to extract the most use of financial statements. Knowing what tricks managers have up their sleeve can help market participants unravel the effects of any manipulation and in the long run blunt the effectiveness of earnings management techniques. In some sense, the onus lies on academics and financial practitioners to focus on the importance of understanding a firm’s accounting practices. A final point regarding the inherent flexibility in financial statements needs to be made. There have been many suggestions in the financial press that the reasons for accounting scandals are the high level of flexibility that managers have in the application of financial standards. In my opinion, the problem lies not in the inherent flexibility, but in the inability or unwillingness of financial market participants to focus on accounting issues when markets are on an upswing. Focusing on accounting issues will allow regulators to keep accounting standards flexible so that firms can use them to best 10 communicate with capital markets as any attempts to manipulate will be ferreted out by market participants with sophisticated “forensic” accounting skills. The current increased emphasis on financial accounting issues is heartening, but this could be a temporary phenomenon related to the morbid fixation people tend to have with bad news – notice the tremendous coverage to accounting related issues at WorldCom, Enron and other firms. The challenge will be to keep this momentum going the next time the markets start to ascend, to prevent future large scale occurrences of accounting fraud. REFERENCES Aboody, D., and R. Kasznick. 2000. CEO stock option awards and the timing of corporate voluntary disclosures. Journal of Accounting and Economics 29, 73-100. Bartov, E. and P. Mohanram 2003. Private Information, Earnings Manipulations, Executive Stock Option Exercises. Working Paper – Columbia University/New York University. Bartov, E., F.A. Gul, and J.S.L. Tsui. 2000. Discretionary accruals models and audit qualifications. Journal of Accounting and Economics 30, 421-452. Burgstahler, David, and Ilia Dichev. 1997. Earnings Management to Avoid Earnings Decreases and Losses. Journal of Accounting and Economics 24, 99-126. Dechow, Patricia. 1994. Accounting Earnings and Cash Flows as Measures of Earnings Performance : The Role of Accruals. Journal of Accounting and Economics 18, 3-42. Dechow, Patricia, Richard Sloan and Amy Sweeney. 1995. Detecting Earnings Management. The Accounting Review 70, 193-225. Degeorge, Francois, Jayendu Patel, and Richard Zeckhauser. 1999. Earnings Management to Exceed Thresholds. Journal of Business 72, 1-33. Hayn, Carla. 1995. The information content of losses. Journal of Accounting and Economics 20, 125-153. Jones, Jennifer, 1991. Earnings management during import relief investigation. Journal of Accounting Research 29 (2), 193-228 11